The biggest invisible stories of the decade: Part 2, dematerialization of global capital

January 6, 2010 | Capital markets, Decade, Essential posts, Global news, Innovations, Regulation, Theory, US News

By: David A. Smith


[Continued from yesterday’s Part 1.]


In this retrospective on the naughty Aughties, I’m concentrating on the biggest hidden stories, the ones we should have noticed but didn’t.  Yesterday we opened the decade with two of them:


2000: David Li publishes On Default Correlation: A Copula Function Approach.

1999: Franklin Raines succeeds Jim Johnson at Fannie Mae


This is a major, seven-part post, best read in order.


If you’ve just arrived, we recommend jump back to Part 1 and start there.



The next invisible event is harder to pin down – literally.


2001: The dematerialization of capital


When I was a kid, financial capital was represented tangible: gold, silver, currency.  Bonds were bearer bonds, stock certificates.  Actual pieces of paper (that’s not an oxymoron) with embossing, stamping, engraving, or certification of authenticity.  Possession of the scrip was critical to proving no-questions asked credit.



Money, though an intangible concept, through 1999 had a tangible expression.


During the Nineties, many indicia of status dematerialized.  Airplane tickets went electronic (when was the last time you saw a paper one?); so did driver’s licenses.



My identity is an illusion, as is everything else here


Most significant in this dematerialization was that of capital.  From having once had a tangible existence, by the time the Aughties opened, capital was evidenced by matching sets of numbers contained in bank and financial institution computers, making a mockery of the old how-to-steal-a-million caper movie that was a screen staple when we were growing up.



From this vision of money …



… to this, art replacing cash


The dematerialization of money reached its cinematic absurdity with Entrapment, whose impossible plot involved breaking into a high-rise to reprogram a computer so it would send an electronic pulse transferring eight billion dollars’ worth of digits, in a story whose climax, with temporal serendipity, occurred on Millennium Eve, 2000.



The plot required this – absolutely essential


Capital’s dematerialization is critical because without it, capital could never be truly global, and with it, capital was ineluctably and irreversibly global.  Ten years later, we still haven’t come to terms with capital’s evanescence, as it has revolutionized and intertwined currency and investment flows.  It’s also vitiated much of foreign aid, turning the effort into filling a sieve [Posted October, 2007]:


That, says Raymond W. Baker of the Global Financial Integrity Project, is why foreign aid fails — because even faster than it is poured into deserving countries, it pours out via illicit financial transactions. 



Raymond W. Baker


As he put it in a recent speech:


I want to talk about two things this morning.  One, the international structure that supports the flow of illicit money across borders, and two the harmful impact these illicit flows have on economic growth and poverty alleviation in poorer countries.


For nearly a decade, Mr. Baker has been on a crusade against illicit capital flows, which he sees as a relatively new development — technology-driven — that is distorting the world:


There are a number of interrelated parts of the illicit financial structure.




I estimate that something on the order of $1 trillion to $1.6 trillion of illicit money moves across borders annually. These estimates are conservative and are developed with some care in my book, Capitalism’s Achilles Heel, utilizing both top-down and bottom-up approaches. Other analysts think these estimates are considerably short of the real global totals.


Drug kingpins, criminal syndicate heads, and terrorist masterminds did not invent any new ways of moving their illicit proceeds. They merely utilized the mechanisms that we had created for the purpose of moving flight capital and tax-evading money.


In this, illicit capital flows use the same hijacking of an efficient network deployed by spammers — they ride along inside, stowaways on other people’s intangible infrastructure.


If Mr. Baker is right, money poured into the top (such as sovereign lending, which is the sole product allowed by the World Bank) can do only so much good as cannot be siphoned off by the corrupt.



“We can painlessly drain bank accounts …”

Now, let’s consider the impact of this estimated $500 to $800 billion of illegal money coming annually out of poor countries.



It eviscerates foreign aid. Through most of the 1990s and into the current decade, aid has been running about $50 to $80 billion a year from all sources. Consider the comparison: $50 to $80 billion of aid in; $500 to $800 billion of illicit money out. In other words, for every $1 that we have been generously handing out across the top of the table, we in the West have been taking back some $10 of illicit money under the table.


I’ve used the foreign-aid flow example because it so perfectly illustrates how, once capital as de-materialized, many of our economic and governmental notions are instantly obsolete.  Mercantilism doesn’t work if value is intangible and jobs are intellectual, for they will be outsourced to India whether you like it or not.  Value creation migrates all around the world and value chains at a stroke become international, as witness the by-now-commonplace experience of dialing local information only to have someone from Bangalore giving you the necessary digits before transferring you seamlessly to someone else in Bismarck. 


Had capital not dematerialized, none of the decade’s capital whipsaws would have been possible.


Aftermath.  Capital’s dematerialization is still part of our world, and permanently so.


Our global capital-finance ecosystem has yet to come to terms with it.  That’s why we keep having massive aftershocks, and will do so for years to come.


2002: The global yield starvation


The dematerialization of capital made money into a rootless wraith, swirling about the globe as if drawn toward yield brightness.  Nowhere was that hunger greater than in aging Europe, whose ever-more-generous social welfare system kept expanding beneficiary expectations (shorter retirement) even as it was shrinking the contributor pool (fewer workers). 



Isn’t it nice to know some young immigrants are funding our leisure?


Partly this was due to their sclerotic land-use and development processes, which choked off new housing delivery (eventually, everything comes back to housing), and in the process cut into Europe’s already waning birthrate:


Europe’s high cost of housing may be partly to blame.  Remember, more bedrooms means more babies.



I got my start when Mom and Dad got a new apartment


[The largest consequence of Europe’s shrinking indigenous work force was the wave of African, Asian, and Middle Eastern immigrant workers, drawn north and west for employment, that now represent Europe’s sole growing demographic segment.  That massive long wave of people, as we’ve seen, has cultural and political consequences far beyond merely the capital markets … which are beyond the scope of this humble blog. – Ed.]



The map of Europe, changing color


With Europe‘s labor pools shrinking and its beneficiary pools both growing and aging, European pension fund managers sought to fulfill against the generous promises hopefully made by quasi-numerate politicians.  As framed in a provocative article by the columnist Spengler, which I used as a post springboard, Europe was starving for yield [Posted June, 2008]:


German banks [Spengler wrote in June, 2008  – Ed.] have written down about US$25 billion in securities derived from low-quality (”subprime”) American mortgages, and doubtless will lose a great deal more. But it is silly to blame the sausage-grinder.  Why didn’t the Germans and all the other overseas investors buy mortgages in their own countries, instead of scraping the bottom of the credit barrel in the United States


It is because there aren’t enough Germans, or Italians, or Frenchmen or Japanese starting families and buying homes.


Spengler did not bother to remark that this flow of capital – from German or French or Italian pension funds into US mortgage-backed securities – was possible only because capital had already dematerialized.  Had capital been tangible, banks would have been geographically bounded, and being so bounded, would have been forced to find their investments at home.


Young people take out big loans to buy big homes.  Old people need investments to produce income.  Hence the emergence of long-term borrowing and lending.


The aging pensioners of Europe and Asia must find young people to pay interest into their pensions, and they do not have enough young people at home. Germans aged 15 to 24, on the threshold of family formation, comprise only 12% of the country’s population today and will fall to only 8% by 2030.  But one-fifth of Germans now are on the threshold of retirement and half will be there by mid-century.



Germany’s getting old …



… much faster than the US



… but not as fast as Japan!


There is nothing complicated about finance. It is based on old people lending to young people.


That’s an interesting way of putting it.


Young people invest in homes and businesses; aging people save to acquire assets on which to retire. The new generation supports the old one, and retirement systems simply apportion rights to income between the generations. Never before in human history, though, has a new generation simply failed to appear.

When you have old people, they want income.  When you have young people, they want cash.  Young people will pledge future earnings (called mortgage payments) in exchange for cash now (called loans).  The mix of young and old thus has a large effect on the price of long-term capital.


The law of economic pressure meant that yield hunger drove European and Japanese capital out of their own markets and into ours [Posted February, 2009]:



Predicated on the dematerialization of capital, I think


For the last decade or more, capital has been global, and as a result, money-investing pressure from elsewhere found its expression in the US.  The result was cheap credit:


Being a commodity, money has a demand – people who go to the money store needing it for investment – and a supply, people who come to the money store looking for yield. 




When the supply of money (that is, people who want to invest) exceeds its demand (quality investments to make), two things happen:


* Yields go down because money becomes cheaper.

* Investments increase as new products are invented and come into the marketplace.


If the world has more wine drinkers than vineyards, marginal soils are planted and plenty of plonk is sold and drunk.


Because of the pricing equilibrium, cheap credit drove up prices of assets like homes. 



We heart US financial assets


Aftermath.  Although globe is still ravenously yield-hungry, but with the illusion of permanent above-inflation returns now shattered, governments around the world are staring bleakly at sovereign bankruptcy.  Municipalities, states, and nations are realizing that they will have to scale back their social-welfare promises either directly (by cutting funding and services) or indirectly (by inflating their currency).  The globe must go on a benefits-yield diet, and the withdrawal is painful.



I did it for my art


[Continued tomorrow in Part 3.]